1.

Outside directors have been pushing Rick Martino to keep earnings growing or face a situation in which he would be replaced by a professional manager who was not within the Martino family. Assuming no changes to the accounting policy for 2008, that the company sells 10,000 units each quarter at a selling price of $2,000 per unit, and the selling, general and administrative expenses are the same as they were in 2007, the net income in 2008 is $5,200,000. In comparison, the net income in 2007 was $7,150,000. Considering this is a 27.3% (rounded to the tenth place) drop in earnings, and the outside directors have been pushing Rick Martino to keep earnings growing, it would be highly probable that Rick Martino would lose his job. However, one must look deeper into the numbers to see what is causing this drop in earnings. When looking at the 2007 Income Statement the sales revenue is $67,000,000. In comparison, when looking at the 2008 Income Statement the sales revenue is $80,000,000, showing sale revenue grew by 19.4% in 2008. Thus it is clear that under Rick Martinos leadership sale revenue is improving from 2007 to 2008. However, when looking at the on the 2007 income statement the cost of goods sold expense is $46,000,000 in comparison to the 2008 pro-forma income statement in which the cost of goods sold expense is $62,000,000, showing a 34.8% increase in 2008. As the selling and administrative expense is the same in each year, this dramatic increase in cost of goods sold expense in 2008 is causing the pressure on sales margin. This pressure is due to a plethora of factors. Under the leadership of Martinos father, management had initiated several strategic decisions which led to the severe increase in cost of goods sold expense in 2008. Originally, Merrimack mowers were manufactured and assembled in a workshop and factory in Nashua. In the early 1980s, management led by Martinos father closed down the last manufacturing operations in Nashua and outsourced manufacturing at to Japanese, and later Chinese manufacturers. The Chinese arrangement worked well as the mowers variable cost, even with shipping costs, was substantially less than it would have been in Nashua. However, in 2008 a number of things had changed. Economic development in China had increased labor and wage costs, which were compounded by a strengthening Yuan in comparison to the U.S dollar. These developments led loyal suppliers to raise prices they charged Merrimack for the mowers. The cost of shipping had also risen nearly threefold from 2000 to 2008 exacerbating the cost of goods sold expense even more. Though it is clear that if Rick Martino reports this result in earnings he will most likely not keep his job, it is essential to understand that if cost of goods sold expense could be minimized Rick Martino may be able to keep his job. 2. The annual balance sheet, as well as the quarterly balance sheets would be affected if instead of selling 10,000 units per quarter which will be labeled scenario 1; Merrimack sold 5,000 in the first quarter, 20,000 in the second quarter, 10,000 units in the third quarters, and 5,000 units in the fourth quarter, which will be labeled scenario 2 to keep things clear. From table 2 it is clear that this change in units sold per quarter leads to a cost of goods sold of $58,000 in scenario 2 in comparison to $62,000 in scenario 1. As the cost of goods sold expense is less in scenario 2 in comparison to scenario 1, the net income is larger in scenario 2 in comparison to scenario 1

leading larger retained earnings on the balance sheet in scenario 2 in comparison to scenario. The reason for this is a decrease in cost goods sold expense, when all else is equal, leads to an increase in net income and an increase in retained earnings. Based on the nature of cost of goods sold and the cost of goods sold equation (BI+P-EI=CGS), there is a clear relationship between the cost of goods sold on the income statement and inventory on the balance sheet. When looking at the cost of goods sold equation from the annual perspective, the beginning inventory and purchases would be the same in each scenario. However, as the cost of goods sold expense is $4,000 lower than in scenario 2 in comparison to scenario 1, the inventory on the balance sheet is $4,000 higher in scenario 2 in comparison to scenario 1. From a quarterly perspective, changing levels of units sold per quarter like that found in scenario 2 leads to varying cost of goods sold expense amounts which leads to varying net incomes and thus varying retained earnings on the balance sheet each quarter. Based on the cost of goods sold equation, these varying levels of units sold per quarter also leads to varying inventory amounts each quarter. In comparison, in scenario 1 each quarter the cost of goods sold expense varies but because each quarters purchase is equal to the cost of goods sold the inventory stays at a fixed amount through each quarter. The net income, however, is variable and changes each quarter leading to a varied retained earnings on the balance sheet. Only when the same amount of inventory is sold in both scenarios (which only occurs in quarter 3) do the cost of goods sold match up leading to the same net income and thus retained earnings on the balance sheet (if assumed all else remains equal). 3. The income statement would be affected as the cost of goods sold expense would be $11,500,000 lower if Merrimack Tractors and Mowers adopted FIFO. This would lead to the gross margin on the income statement to be $11,500,000 higher. As selling, general, and administrative expense would remain the same in both situations, the pretax income would be $11,500,000 higher which leads to the the income taxes expense (which is 35 percent of pretax income) to be $4,025,000 higher. The net income, after subtracting the income tax expense from the pretax income, would be $7,475,000 higher. This net income increase would lead to the retained earnings on the balance sheet to be $7,475,000 higher. As cost of goods sold expense would be $11,500,000 lower, based on the cost of goods sold equation, the inventory on the balance sheet would be $11,500,000 higher.

Because we are selling a different number of units per quarter, the cost of goods sold varies from the first example. Cost of goods sold effects inventory on the balance sheet. As the cost of goods sold increases inventory decreases. In addition, an increase in net income would also lead to an increase in retained earnings on the balance sheet.

4. When Merrimack sells 10,000 units per quarter and purchases 10,000 in that same quarter, the result is a consistent ending inventory of the beginning inventory (or 15,000 units at $900 per unit). The net income This results in an inventory balance of $13,500 each quarter and on the annual balance sheet. In contrast when the number of units sold per quarter changes each quarter the cost of goods sold each quarter varies. This varying cost of goods sold causes varying net incomes and thus varying retained earnings. An increase in cost of goods sold causes a decrease in net income and a decrease in retained earnings on the balance sheet. Similarly, a decrease in cost of goods sold leads to a decrease in net income and decrease in retained earnings on the balance sheet.